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Business Bankruptcies on the Rise


A record number of companies are filing for bankruptcy

The year 2007 started well for for Jay Allen and his wife, Sarah Lee-Allen. The couple had earlier borrowed $850,000 from California Bank & Trust to buy Tucson-based Omega Wallbeds, a seven-employee custom wallbed maker. Sales were so brisk that the Allens were repaying the loan at a rate of $9,000 a month, a nice chunk over the monthly minimum of about $8,500.

But by summer—usually the company's slow season—sales unexpectedly dropped 10% from the prior year. "The folks who were buying second or third houses stopped buying [them] because the economy was slowing down. That's what hit us really hard," says Lee-Allen, 61, a former sales and product management executive. Omega started missing payments in July.

Omega Wallbeds filed for Chapter 11 on May 8, after the Allens and their lawyer spent months trying to negotiate with the bank. (A spokesman for California Bank & Trust said the bank is prohibited from commenting on individual cases because of privacy concerns.) "If they'd given me a little more time, because we had a very good winter, I could have paid all the money," says the 58-year-old Allen. The Allens hope to restructure the debt, counting on the fact that annual sales continue to grow—to $550,000 in 2007, up from $430,000 when they bought the business in 2006.

Omega is one of a growing number of small companies pushed into bankruptcy by a combination of tight credit, inflation, and a weak economy. More businesses filed for bankruptcy in April, 2008, than in any month since October, 2005, when changes to bankruptcy law made it more complicated and more expensive to file. On average, 235 commercial bankruptcies were filed each day in April, the most recent month for which data are available, a 49% increase over the same month a year ago. That figure includes Chapter 7 liquidations, Chapter 11 reorganizations, and Chapter 13 filings, which let debtors keep their assets while repaying creditors. Also in April, the number of commercial filers topped 5,000 for the first time since the law was changed, up from 4,724 in March, according to data compiled by Oklahoma City-based Jupiter eSources, which tracks bankruptcy filings through its AACER database.

"The economic pressures have been building for some time," says Howard Brod Brownstein, principal at NachmanHaysBrownstein, a Narberth (Pa.) turnaround management firm. "What had been kind of modulating [them] was the tremendous amount of liquidity that had been available in the marketplace. That liquidity has really dried up in many areas, and it has particularly dried up for smaller companies."

Experts say the alarmingly high number of bankruptcy filings actually understates the number of business owners in trouble. Robert Lawless, a professor at the University of Illinois College of Law, says that statistics fail to count many sole proprietors who do not file for bankruptcy under a business name or taxpayer identification number. "One in seven people who file for bankruptcy tell us they are self-employed at the time of filing," Lawless says, even though government figures attribute only 3.3% of all bankruptcy filings to business-related debt.

Plus, companies increasingly are turning to nonbankruptcy settlements to resolve their debts, further suppressing the number of bankruptcy filings. Many businesses without creditors simply close up shop rather than spend $5,000 to $10,000 to file for a Chapter 7 liquidation, which, unlike Chapter 11, does not allow for a reorganization.

Filings rose the fastest in areas hit hardest by the housing bust. California's share of commercial bankruptcies grew to 19% in the first four months of 2008 from 11% in 2006. In Florida's Southern District bankruptcy court, the number of filings from the first four months of 2008 matched the total for all of 2006. Both states have metro areas in which home prices have dropped by more than 15% in the past year, according to real estate tracking site Zillow.com.

CREDIT-CARD CRISIS

Falling home values mean entrepreneurs who once relied on home equity to finance their ventures have seen that option disappear. Julianne Frank, a partner at Palm Beach Gardens (Fla.) bankruptcy law firm Frank, White-Boyd, says business bankruptcies have spread beyond developers, subcontractors, and suppliers to other sectors including autos, retailing, and restaurants. "There seems to be a steady rise in the financial distress that is out there," Frank says.

Heavy reliance on credit-card debt can push businesses into bankruptcy as well. A study of California small business owners who filed for bankruptcy in 2005 noted that as much as one-third of their initial financing came from credit cards, according to California State University, Northridge, professor and study author Rafi Efrat. "Given that credit-card debt played an important role in many small business owners' bankruptcy filings during relatively good economic conditions, I would expect the same or even more dire findings to exist now," Efrat says. With credit of all types remaining tight, the wave of business bankruptcies may have yet to crest.

Back to BWSmallBiz June/July 2008 Table of Contents

Tozzi covers small business for BusinessWeek Online. Barrett is a senior correspondent for BusinessWeek SmallBiz.

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